In a very uncertain global economy, we’re finally getting some certainty from the world’s two largest economies – at least on the political front. In the U.S., the interminably long election season finally ended with the re-election of President Barack Obama. Meanwhile, halfway around the planet in Beijing, a congress of China’s Communist Party, which begins today (EDS: Thursday), is expected to finally anoint Xi Jinping as the nation’s next leader. The two political processes couldn’t be more different – one politician fought for his job on CNN, the other maneuvered behind tightly sealed doors – but the outcome of each is equally important for the global economy. What happens with growth, jobs and investment around the world will depend to a healthy degree on the decisions taken by these two men.

The common perception is that one of these leaders faces a bigger economic headache than the other. Obama will have to resolve the fractious battle over how to close the government’s yawning budget deficit before the nation falls off the fiscal cliff, bring down stubborn unemployment and recharge American competitiveness. Xi, meanwhile, seems to be sitting pretty. Growth in China has slowed, but to a rate that remains the envy of the world, while Chinese industry continues its march onto the world stage.

But in this case, looks can be deceiving. Sure, Obama has tremendous economic problems to resolve, but Xi’s challenge is just as daunting – perhaps more so. Obama has to dig the U.S. out from the baggage of the last financial crisis, but Xi has to undertake sweeping reforms to ensure China doesn’t fall into a crisis.

When I write about China potentially facing an economic crisis, I often get laughed at or verbally abused. The official People’s Daily accused me of being a “China basher.” This is part of China’s problem. Any attempt to have an open and honest discussion of what is really happening inside the Chinese economy gets shouted down. But that doesn’t solve the underlying flaws in the Chinese economy. It is easy to keep growth rates high when policymakers pump money into the economy to fund the grandiose schemes of state enterprises or to build more infrastructure. But such an investment-led growth model inevitably leads to a debt crisis. Money gets used inefficiently, debt levels rise, excess capacity gets created, and in the end, the system collapses.

There is no shortage of signs that China is experiencing these very problems. Wind farms have been erected but not connected to the electricity grid. Hundreds of solar cell makers will likely go under. Shopping malls get built where no one shops. HSBC analyst Zhiming Zhang, in a fascinating October study, showed how the problems of the steel industry encapsulate how China’s growth model can be rotting at the core even as it continues to post high rates of growth. Despite record liabilities (of $445 billion for the top 80 mills in the first half of 2012) and massive losses, the industry keeps expanding. Here’s a bit of Zhang’s analysis:

China’s enduring love affair with steel has serious implications for the whole country and beyond…It is also a case study of a fragmented state-owned industry, like others in China, that feels the need to keep expanding even when production and capacity levels are commercially unviable. Indeed, the steel sector is an example of the macro versus micro contradiction at the center of China’s growth model. On the one hand, at the macro level it is positive for GDP growth. On the other, it highlights the overcapacity, overproduction, and debt at the company level in a sector that underpins national fixed-asset growth…State-owned steel companies can fund expansion through bank loans or the bond market; most are rated ‘AA’ or above – remarkable for an industry that is losing so much money…So the message is beware, macro numbers often don’t tell the micro story.

Fixing these issues requires more than a tweak here or there. The reforms that Xi must undertake are no less fundamental than the ones started in 1979 by Deng Xiaoping. Back then, China was a closed, command economy. Deng opened China up to the world, rolled back the state and allowed the rise of private enterprise. Today, Xi needs to drastically alter the nature of the economy again. The state-led, investment-driven growth model is running on empty; the economy needs to become more balanced and more market-driven, with better rule of law. Do not think this is an easy transition. There are many powerful players benefiting from the current system – from SOEs to the bureaucracy – that will attempt to thwart such changes. Xi will need to show a ton of political will to push through the necessary reforms.

Scale back state enterprises. Much of China’s growth story has been a private sector story as Deng’s reforms unleashed the entrepreneurial spirit of the country’s massive populace. But in recent years, that trend has been somewhat reversed. State enterprises have gained in influence, especially since the massive stimulus program instituted by the government after the 2008 financial crisis. SOEs gobble up a large share of the available bank credit; they also receive subsidized land, energy and other inputs. The problem is that they are far less efficient than the private sector. Studies routinely show that SOEs are not as profitable as private companies. Take away their subsidies and their profits evaporate, one influential study proclaimed. That means the nation’s resources are being consumed by an inefficient part of the economy. This situation can’t continue. Xi is going to have to roll back the power of the SOEs and force them to become better performers. That means opening up more of the domestic economy to real competition.

Encourage the country’s consumers. Though China is still a developing nation that requires a ton more infrastructure and apartment buildings, the economy as it stands right now is far too dependent on investment. Xi has to “rebalance” the economy to give it more engines of growth. That means finding ways of encouraging the nation’s consumers to play a bigger role in the country’s economy. To do that, the government has to provide a stronger social safety net – better healthcare, a more reliable pension system – to convince consumers that they don’t need to save as much for the future. Policymakers also must liberalize interest rates. Right now, interest rates are controlled in ways that subsidize industrial investment but offer poor returns to the average saver. Freeing up interest rates would simultaneously make investment more rational and provide more disposable income for households.

Develop a real financial sector. Liberalizing interest rates, however, will also put pressure on China’s banks. Right now, rates are set in a way that allows the banks an automatic profit. Ending that system would force the banks to compete and become more commercially oriented. That’s good for the economy over the long term, but it will be destabilizing in the short run. Chinese banks are still not strong enough in credit analysis and still too directed by bureaucrats to operate soundly in a more open financial environment. If China wants to move forward, policymakers have to strengthen its banks and other financial institutions and better prepare them for a more competitive, more liberalized market. This will also help to ensure credit gets allocated more intelligently and alleviate the problem of excess capacity.

Strengthen rule of law. Chinese officials like to say that China is a “country of rules.” There are a ton of regulations and rules to follow even on the simplest of matters. But having a lot of rules is very different from having rule of law. The fact is that bureaucratic decisions are erratic and inconsistent. Rules are not applied equally or fairly. Many regulations are left purposely vague to give bureaucrats more power. Officials pressure companies to follow government preferences that aren’t actual rules on the books. The court system is a joke. This creates a level of uncertainty that hampers investment and gives the politically connected an advantage. All economies eventually fail on a lack of rule of law. China must fix this problem by fostering an environment in which regulations are clear and applied fairly.

Will any of these reforms actually happen? The hope is that Xi Jinping will be more reform-minded that his predecessor, outgoing President Hu Jintao. But the fact is that we know very little about Xi’s true opinions on major economic issues (or, for that matter, on any significant issues). Xi has risen to the top by a process of consensus within the Communist Party, which means he has had to appeal to both its more liberal and more conservative elements. Yet the truth is that Xi must be a reformer. If not, the Chinese economy could be headed for something ugly. That’s not good for Xi, China, or the world.

Really it is a good job. Well done. As a leader is always responsible for
all performance this is a good quality of a leader to prevent the crises which
was done by the china's new leader. No doubt china is a developed country and
financially strong. In case of export and import it is comes second position in
whole over the world. So why the responsible of this country’s leader is more
than other.

This links to Hong Kong Phoenix TV's essay about how the leaders of China have had 77 special seminars in 10 years where 155 lecturers come and conduct learning and discussion sessions. This is amazing humility and hunger for best practices. That explains a lot of why China has for 34 years been able to march on overcoming difficulties and march on more. The like of Shuman just have not done their home work and simply pontificating showing their shallowness. Just one. Everyong who is slightly knowledgeable about China watches, as I have, the October Golden Week for the spending of holiday Chinese people. This year the spending was 40% more than last. Traffice jams grid-lock numerous highways and still they went happily spending. The leaders were probably shown projections and studies that without any special stimulus, the citizens seemed to be acting on their own. So let it rise. And Schuman shows his laziness. As for education in science and technology, against plans already started two years ago could have told Schuman the fantastic increase in the science and technology promotion of Hu and Wen. Open-minded folks please get someone with Chinese facility to view this link with you. You will be amazed.... We have a Chinese saying "When wise ones are governing, there will be peace all under heaven." Continued learning is the wisest.

If you say china will meet many problem in economy, I would like to say the USA will be meet more that it. Firstly, USA people includes OBAMA knows economy crisis also existing on your country. Then USA borrow China many many MONEY, do you know? And this money numbers have excessed other countries'. The china's economy cirsis is how to deal with the USA meet more economic cirsis. You can asked your country leader Obama, how many money did you borrow and will be borrowed from other countries,especially from China Finally, the United State American, please do not any hurting other countries actions. There is one sentence in China: If you hurt others, meanwhile, you also will get misfortune. Please American remember it.

So, the author concedes that China's rapid rise is NOT the result of free market capitalism. State-directed, export oriented growth is the basis for China's progress. A continued balance between state directed projects and privatization will be necessary for momentum, including more domestic consumption. If China needs more infrastruture and more affordable housing then that is precisely the area in which the state can play a key role.

What the article entirely misses is the POLITICAL aspect of China's conundrum. It is not curious that Mr. Free Marketeer Schuman falls for the bait of economic determinism ("capitalism cures all ills.") When he speaks of the "rule of law" Schuman seems to mean something like "tort law." How can those negatively impacted by the state or economic manipulators receive some sort of redress. But tort law reform will not advance because of the larger political and legal reform issues of democracy and human rights. Isn't it convenient for the corporate bureaucratic class of Time-Warner to neglect the fundamental political and legal issues of rights ad democracies? After all, the Chinese market is too big to for "us" be concerned with such trifling issues as human rights and the vote.

Americans are as enslaved to corporate oligarchy as Chinese are to the CCP.

@JamesChess "China is a country where state controls capital."I agree with you totally. China is a developing country. That is why investment is quite effective to promote business in China. Much more is waiting to be invested. Facing a crisis, Chinese government has much more power to control the overall situation. Free market promote innovation and blooming of business. At the meantime, crisis may come from that. The role of the government is to offer positive guidance or control to avoid business going to a wrong way.